Topic 8: Understanding Small Businesses

1. Topic 8: Understanding Small Businesses

2. An Overview 1. To What Extent Do the Self Employed Lie About Their Earnings To Household Surveys ? o Subtitle: Can we trust the income data in household surveys? 2. How much do ex-ante differences in motivations to start a small business explain differences in ex-post small business outcomes? o Subtitle: Is it correct to equate small business owners with “entrepreneurs”? How Important are Liquidity Constraints to Small Businesses? How Important are Non-Pecuniary Benefits In Explaining the Behavior of Small Businesses? o At a minimum, how should one think about small business dynamics in a world where non-pecuniary benefits are important?

3. Part A:Standard Model: Liquidity Constraints and Small Business Formation

4. Why Do People Start Businesses? Small Business Skills (Innovators) (Schumpter (1934), Evans and Jovanovic (1989)) Risk Preferences (Kihlstorm and Laffont (1979), Jovanovic (1979)) “Jack of All Trades” (have better management skills) (Lazear (2005)) Two major questions in the literature: Why can’t innovation take place in the existing firms? Can the new firms get financing?

5. Choice: Become a worker: Earn wage: (wζ) Become an “entrepreneur”: Earn income: ( ) where: θ is entrepreneurial ability (know when making choice) k is capital necessary to start a business α is returns to scale on capital: Note: Assume innovations to w and y are uncorrelated. Assume that ability (θ) is uncorrelated with market wage. Assume risk neutrality. Evans and Jovanovic (1989)

6. Entrepreneurial Income: where: z is initial wealth Constraint: Firms can at most borrow λ times their initial wealth to fund their capital project. Note: Borrowing rate = lending rate = r (same for everyone). Evans and Jovanovic (1989)

7. Optimal Capital Stock

8. Probability of Entrepreneurship Increasing in Wealth

9. Entrepreneurial Income as a function of constrained/unconstrained k. Finish Solving The Model

10. Compare Entrepreneurial Earnings to Wages

11. Richer households are less bound by liquidity constraints and as a result • are more likely to enter entrepreneurship. • Should see a positive relationship between initial wealth and entry into • small business ownership. Evans and Jovanovic Conclusions

12. Part B:Testing for the Importance of Liquidity Constraints

13. Old School Tests of Liquidity Constraints for Entrepreneurs Basically, the majority of empirical papers regress business ownership (the propensity to become a business owner, the propensity to survive as a business owner) on household wealth. Prob (Start Business (t, t+1)) = α0 + α1ln(Wealth(t)) + γ X + ε Early research concluded that if wealth is significant in predicting business entry, liquidity constraints are binding. (i.e., α1 > 0) Approach taken: Evans and Jovanovic (1989, JPE) Evans and Leighton (1989, AER) Fairlie (1999, Journal of Labor Economics) Quadrini (1999, Review of Income and Wealth)

14. Limitations of Approach Is the level of wealth exogenous from other factors that cause entrepreneurial entry? o High ability earn more (accumulate more for retirement) and may be better at innovating. o Risk preferences can cause high wealth and taste for entrepreneurship o People planning for self employment accumulate assets for their retirement (do not have pensions). Next Generation of Studies: Try to find an “instrument”.

15. Inheritances as an Instrument • Instrument for wealth - look at liquidity windfalls which are uncorrelated with the decision to become an entrepreneur. o Many use inheritances as instrument. o Find inheritances are strongly correlated with entrepreneurial entry. o Receiving an inheritance in year t predicts entrepreneurial entry between t and t+k. • Holz-Eakin, Joulfaian, and Rosen (JPE, 1994) • Blanchflower and Oswald (1998, Journal of Labor Economics).

16. Up Though 2003: Conventional Wisdom • Liquidity constraints are an important deterrent to small business formation. • Liquidity constraints to small business formation is an important explanation of the dispersion in wealth (rich people keep accumulating wealth to relax their liquidity constraint for their small business). o Cagetti and DeNardi (2006, JPE). • Welfare costs of liquidity constraints to entrepreneurship is large o Buera (2009, Annals of Finance) Note: Both papers use as the basis of their models, the relationship between wealth and starting a business using household micro data.

17. A Re-Evaluation of The Facts Liquidity Constraints, Household Wealth and Entrepreneurship? Erik Hurst University of Chicago and NBER Annamaria Lusardi Dartmouth College and NBER

18. Goal • Are people interpreting the data correctly? This paper • We think that the relationship between wealth and small business start-up using micro data (or firm level data) is not what people think.

19. Some Facts About Small Business Owners • How much money do small business owners need to start their business? • 1987 NSSBF: Median amount of capital to start a business is $22,700 25% start with less than $5,000 • 1982 Characteristics of Business Owners (Meyer 1990) report even smaller figures: • 63% of non minority males and 78% of black business owners started with less than $8,700 (1996 dollars) • Inc Magazine 500 fastest growing companies in the U.S. (Bhidé 2000) • 26% started with less than $5,000 in upfront capital • Median was not much higher.

21. What We Do in this Paper • Formally Test The Importance of Liquidity Constraints and Business Ownership • Examine the relationship between own wealth and business entry • Examine the relationship between parental wealth and business entry • Look at the wealth/business entry relationship by types of business • Instruments for wealth changes • Inheritances • Capital gains on housing. • Look at survival probabilities

22. Data Source • Panel Study of Income Dynamics (PSID) • Can follow households in and out of business ownership. Business ownership is asked in every year. Business wealth (and all other wealth) asked every five years starting in 1984. • Main sample of analysis focuses: Stacked panel: Transition into business ownership between 1989 and 1990 and Transition into business ownership between 1994 and 1995 Focus on: Non business owners Households aged 22 to 60 Sample size: 7,645 observations (almost 5,000 distinct households). For some analysis, we will only use the 1989-1990 panel (occupation and industry codes are not available beyond 1993). 3,645 observations.

23. Initial Methodology • Run three different types of regressions Prob (Start Business (t, t+1)) = α0 + α1 Wealth(t) + γ X + ε Prob (Start Business (t, t+1)) = α0 + α1 Wealth(t) + α2 Wealth(t)2 + α3 Wealth(t)3 + α4 Wealth(t)4 + α5 lnWealth(t)5 + γ X + ε Prob (Start Business (t, t+1)) = α0 + α1 Dummy_Wealth_80-95 + α2 Dummy_Wealth_95+ γ X + ε • X includes controls for age, education, income, family structure, prior employment status, and prior business ownership. • Wealth is defined as the sum of savings and checking accounts, bonds, stocks, IRAs, housing equity, other real estate, and vehicles, minus all debts.

26. Importance of Parental Wealth

27. Wealth and Business Start Up by Industry • Wealth should be more important for starting a business with high starting capital requirements. • You need to be rich to start a car factory. However, wealth should not matter much to start a house-cleaning business. We explore heterogeneity in starting businesses of differing starting capital amounts. Perhaps the heterogeneity is masking evidence that liquidity constraints exist. Create Two Categories: • Low Starting Capital (Construction and Services) • High Starting Capital (FIRE, Manufacturing, Transportation, Wholesale and Retail Trade, Communications) Note: PSID has two additional industries: Farming and Professionals We will look at professionals separately

29. What about Inheritances as an Instrument? • Fact is replicated in our data set. Is the case closed? No…… Why? • Many business are transferred at the time of death (5% of NSSBF sample) • More importantly, inheritances are not randomly distributed in the population. Those who get inheritances are just different (on average) from those who do not. A counterfactual…… Test of the latter proposition  Do future inheritances (received after the business is started) predict current business entry?

31. A New Instrument We use an alternative measure of liquidity: Regional variation in housing prices. Much evidence that households do borrow against home equity to sustain consumption or finance investment projects. • Brady, Canner and Maki (2000) – 20% of those who removed equity during the late 1990s when refinancing used it to fund business investment. • Hurst and Stafford (2002) – find household who lost their jobs in the early 1990s used home equity to prop up consumption. We predict that households who receive increases in home equity – all else equal – should have access to more liquidity. Are they more likely to start a business? We find NO effect of housing capital gains on business entry!

32. Some Additional Facts about New Business Owners

33. Conclusions (part B) • Our findings do NOT promote cutting funding to the Small Business Administration (SBA). Part of the reason why liquidity constraints may not be binding is because of SBA policies. • Existing evidence on the existence of liquidity constraints for small businesses not very conclusive. • Why is it the effect is so large for the really rich? Outstanding Questions: • Are the business owners in typical household or business survey important for economic growth? • Are there existing households who would start a profitable business if they had wealth that just are not showing up in the data? • What drives business ownership decisions for median household?

34. Part C:“What Do Small Businesses Do?”(with Ben Pugsley)

35. Some Background There is a disconnect among researchers and policy makers between the theoretical/conceptual models of “entrepreneurs” and the “universe of small business owners” on which we test theory/implement policy. o “Bill Gates” types (conjecture: they are rare) Match the theoretical concept Innovate, efficiently share risk, has new idea/product, wants to grow, innovation has social spillovers, etc. o “Joe the Plumber” types (conjecture: they are not rare) My brother Does not want to grow, does not want to innovate, very content staying small, does not innovate ex-post, etc..

36. Some Outstanding Questions Question: What drives the decision to become a small business owner for the “Joe the Plumber” types? Question: How do these other small businesses respond to the incentives we provide to stimulate entrepreneurial activity for the “Bill Gate” types? Question: Do individuals really want to innovate and/grow when they start their business?

37. Data Sources To answer these questions, we are going to use a variety of data sources from: Statistics of U.S. Businesses (SUSB) – maintained by Census using data from U.S. Business Register. o Focuses on employer firms (excludes non-employers) National Survey of Small Business Finances o Focuses on firms with between 1 and 500 employees Kauffman Firm Survey – Survey of new businesses; has panel dimension Panel Study of Entrepreneurial Dynamics – Survey of new businesses; has panel dimension.

38. Some Background Facts ~ 6 million employer firms in the U.S. in 2007 Aside: ~ 22 million non-employers (which comprise about 4% of payrolls) About 90% of employer firms have less than 20 employees. About 20 percent of employment in is firms with less than 20 employees.

39. Some Background Facts

40. Who Are The Small Business Owners? Define small business owners as those with less than 20 employees (or 100 employees). Use data from the 2003-2007 Statistics of U.S. Businesses (SUSB) – compiled by the U.S. Census. Group all small businesses (across all industries) into 4-digit NAICS industries (there are about 300 4-digit NAICS codes). Define: xj is share of small business in industry j out of all small businesses.

41. Small Businesses (< 20 Emps) by 4 digit Industry Note: This patterns hold adjusting for industry size.

42. Small Businesses (< 20 Emps) by 4 digit Industry Note: This patterns hold adjusting for industry size.

43. Small Businesses (< 20 Emps) by 4 digit Industry Note: This patterns hold adjusting for industry size.

44. xj vs. within industry share of small firms

45. Heterogeneity in Ex-Post Small Business Outcomes Most small businesses do not grow Most small businesses do not innovate Traditional Explanations - Differences in Luck - Differences in Ability - Differences in Constraints (ability to borrow/self finance)

46. Most Small Businesses Do Not Grow (Stay Small)

47. Most Small Businesses Do Not Grow (Stay Small)

48. Survey of Small Business Finances: Business Growth

49. Kauffman Firm Survey (KFS): Business Growth Survey tracks new firms (on eve of establishment): Focus on survivors.

50. Small Business Gross Job Creation Most small firm gross job creation does NOT occur in the industries which are dominated by small businesses. To the extent small businesses create jobs, it is not in the skilled craftsmen, skilled professional, and small shopkeeper sectors. Google created a lot of jobs. Google doesn’t look like the typical small business.